Agricultural commodities are a major part of the global economy, representing a unique and often lucrative opportunity for investors. In general, commodity investing involves raw materials that are directly consumed, like food or are used to create other products. Investing in a global rice company would be one way to have exposure to commodities for example, but there are others, like ETFs.
Below, we highlight some of the more important and significant things to know about investing in agricultural commodities.
Why You Should Consider Commodities
Even outside of agricultural commodities, investing in commodities, in general, can be a smart idea but it carries risk.
The assets most commonly traded are stocks and commodities. With commodity trading, you are investing in physical products or raw materials, whereas stock is a representation of ownership in a company. Investing in commodities is based on supply and demand, but if you invest in stocks, it depends on the financial health and performance of the business.
You can see how in the current economic environment, there might be upsides to commodity investing.
Commodities are often short-term investments with a faster return, while stocks are viewed as assets that you hold for long periods, hopefully maximizing your returns.
To invest in commodities, you can use Exchange Traded Funds, Agricultural Mutual Funds, and Futures Contracts.
By 2040, it’s expected the world’s population will be more than nine million, and people will be richer, with analysts estimating that the biggest gains in wealth will be in the developing world. Wealthier people around the world will mean the demand for agricultural products will likely continue to grow.
Understanding Agricultural Commodities
Agricultural commodities can be a food source and also an ingredient used in industry. For example, corn is something that animals and humans consume, but it’s also an ingredient in fuel production.
Essentially every living being that’s on earth depends on the agricultural industry in some way or another.
It’s estimated that 20% of the world’s population work in farming, especially in certain regions like Sub-Saharan Africa and South Asia.
We briefly touched on the three ways you can invest in commodities, which we detail more now.
First, an Exchange Traded Fund or ETF trades like other stocks, but they’re a collection of multiple stocks. You can buy a share in an ETF just like you would for a publicly traded business.
If you’re investing in an agricultural ETF specifically, it would include companies with revenue that’s at least half from agricultural sources. There are also ETFs that are specifically for agricultural commodities such as wheat, sugar, or corn.
Another option is an Agricultural Mutual Fund, where you’re investing in a lot of stocks at a lower price. There’s a pool of investors who are collectively investing in commodities. You’re buying a portfolio that’s professionally managed, lowering your risk.
Futures contracts are the most common route investors take when they want exposure to agricultural commodities. Futures contracts are legal agreements where you’re committing to buying or selling an asset within a timeframe that’s agreed upon in the future. As the buyer, you’re using leverage to buy more commodities, with the prediction that the value of the asset will go up once the contract ends.
When the contract ends, you then sell the shares, and that’s when you get your return.
Global supply and demand, and also seasonal factors, significantly impact futures contracts. They came about in the agricultural industry specifically as a way of balancing market prices to lower the potential risk for investors.
Along with the three options above, some people invest in physical raw commodities like precious metal bullion, although that’s not agricultural. Commodities can also include oil and gas.
The Ups and Downs of Investing in Commodities
There are pros and cons of commodities investing.
One pro of this approach is the element of diversification. Over time, there are often differences in returns with commodities and commodity stocks compared to other stocks and also bonds. If you have assets that aren’t correlating with one another, it’s a better hedge against market volatility, which might be particularly appealing in the current market environment. Of course, diversification doesn’t mean you’re guaranteed to make a profit or be protected against loss.
Another possible benefit of commodities investing is the potential returns. The prices of individual commodities fluctuate because of supply and demand, inflation, and the economy. There has been increased demand globally recently for food-related items because of supply chain issues and inflation.
Speaking of inflation, investing in commodities can be a potential hedge against it. Inflation can erode the value of stock and bonds, meaning higher commodity prices. During periods of high inflation, as we’re in right now, commodities have historically shown strong performance if you’re prepared to weather their extreme volatility.
So, what about the risks?
The main risk of agricultural commodities investing is what has been talked about throughout this guide—volatility. The commodities industry is heavily impacted by world events, economic conditions, government regulations, and competition. These all impact the prices of commodities, meaning that your investment is always at risk of losing value.
When a mutual fund tracks a single sector or a single commodity, it can have higher-than-average levels of volatility, and any fund using futures or options can also see more increases in volatility.
When you invest in commodities, you’re creating more exposure in your portfolio to foreign and emerging markets, and that means that you’re at risk of the effects of economic, currency, and political instability.
While you’re using commodities likely as a way to diversify, the actual funds that you might be used as investment vehicles aren’t considered diversified because they usually have securities focused on one or two industries.
If, as a result, there’s a change in the market value of one investment, it could lead to bigger fluctuations in share prices than what you’d see with a fund that’s more diversified.
Finally, when stock funds that are focused on commodities use futures contracts for tracking an underlying commodity, it’s speculative trading, which is high-risk.